the US Department of Defense DoD incurs substantial obligations denominated in foreign currencies through the overseas operation of its four military services
1
. Like enterprises engaged in international procurement, military services may be
required to settle using a supplier’s local currency. In addition, the establishment of a significant overseas US military presence in the post-war period has entailed a
considerable economic exposure for the Department of Defense. In the process of fulfilling US alliance and security agreements, the DoD’s overseas activities, like
those of a multinational firm engaged in overseas production, involve a number of costs and receipts denominated in currencies different from that in which the DoD
is funded.
This paper examines DoD foreign exchange rate exposure in light of the government’s prohibition against foreign currency hedging. Using data from the
United States Air Force and Monte Carlo simulation, we evaluate whether the use of forward foreign exchange contracts or currency options might reduce the
financial impact of currency fluctuation. The results strongly indicate that these alternatives outperform the current method for dealing with foreign currency
exposure in the DoD. Using forward contracts, expected cost reductions are on the order of 3.5 of current outlays. For options, expected cost reductions increase to
6.4 thereby defining a 2.9 upper bound on acceptable option premium levels.
We present our findings in the following manner. Section 2 describes the current process used by the DoD to record and monitor its foreign currency exposure. The
international economics and multinational finance literature is helpful in placing these procedures in context. Section 3 presents the model and simulation method by
which we compare the DoD’s current unhedged approach to budgeting foreign expenditures with an alternative using forward currency contracts. Section 4
presents the simulation results and their application to currency options. Opportu- nity costs implicit in maintaining the current procedures are also explored. Sum-
mary and conclusions follow.
2. Foreign exchange transactions
The magnitude of the DoD’s foreign currency exposure would evoke consider- able efforts to control if incurred by a private enterprise. For context, we briefly
contrast methods for addressing foreign currency fluctuations employed in the private sector with the DoD’s current system.
For private firms, numerous procedures exist to counter the adverse conse- quences of foreign currency fluctuations. The literature on exchange rate pass-
through focuses on the ability of a firm to adjust its customer pricing in response to changes in exchange rates Baldwin and Krugman, 1989; Marston, 1990.
Lacking the ability to pass such costs along to the consumer, a firm may respond to currency movements by switching the location of production, as countries with
1
The 5.6 billion is the result of the overseas operations and maintenance expenses of the US Air Force between fiscal years 1991 and 1996.
weak or weakening currencies provide relatively lower cost manufacturing environ- ments De Meza and Van Der Ploeg, 1987. Alternatively, firms may offset their
foreign exchange risk by using various hedging mechanisms available in the financial markets Taylor and Mathis, 1985. Mello et al. 1995 modeled the
relationship between production flexibility and the hedging strategies of multina- tional firms. They found that the ability to respond to prevailing exchange rates by
relocating production determined the need for a hedging strategy while the applica- tion of hedging techniques influenced the location of production.
In the case of DoD foreign currency exposure, these latter two alternatives are unavailable. It is politically infeasible for the DoD to exit a country or otherwise
relocate military forces between countries in response to exchange rate movements. This inflexibility relative to the location of defense ‘production’ is matched by an
inability to employ standard hedging products offered in the financial markets. Pentagon regulations restrict all foreign currency transactions other than for spot
within two business days delivery DoD Financial Management Regulation — Foreign Disbursing Operations, Volume 5, Ch. 12. The use of currency options
and derivatives is prohibited by law and forward contracts require the express authorization of the Office of the Under Secretary of Defense-Comptroller.
These proscriptions seem reasonable and necessary considering the responsibility to ensure proper stewardship of public funds and the general inability to predict
future exchange rates. Taking a position on foreign currency movements relative to the DoD’s overseas financial obligations is perceived as speculative and improper.
Similarly, to avoid cost-of-funds issues, Pentagon regulations disallow payments prior to the receipt of goods or services, such as premium or margin amounts. The
DoD deals with the inevitable fluctuations in exchange rates by formally ignoring them. This risk-neutral behavior may stem from the wealth position of the
government relative to the DoD’s foreign exchange exposure, as well as the government’s ability to pool risks and extract resources.
The DoD’s inability to apply hedging mechanisms and its unwillingness to appraise future exchange rates constitutes what can be termed a ‘naı¨ve approach’ to
foreign currency exposure. This practice has analogies in the private sector see Klein and Katschka, 1992 for an empirical study of corporate naı¨ve strategy. For
many firms, the exposure to foreign currency risk is, like the DoD, small relative to overall operations. Consequently, there is little incentive to incur the cost of
developing and maintaining a proactive approach to counter these exposures. However, the magnitude of DoD foreign currency obligations in an environment of
declining real defense funding warrants further investigation
2
. As a result of its naı¨ve approach to foreign currency exposure, the DoD relies on
exchange rate pass-through to the taxpayer. The DoD’s exposure originates in the difference between exchange rates applied at the time of program budgeting and
those applied when paying final outlays. Each currency’s yearly budget rate is determined by the Office of the Secretary of Defense based on the spot exchange
2
For example, in fiscal year 1998, 2.8 billion was obligated for overseas operations and maintenance expenses.
rate at an arbitrary point in the budget formulation process
3
. Due to the nature of defense budgeting, initial budget rates are set well in advance of liquidation. The
inevitable differences in the ex ante budget rate and the ex post liquidation rate produces variances between the amounts available and the amounts required to pay
specific obligations.
Prior to fiscal year FY 1979, these differences were absorbed in the annual DoD operating budget or by a reduction in the scale or scope of overseas activities. In
both cases, the effects of currency fluctuation were passed along to the taxpayer. Beginning with FY1979, Congress established an account to deal with losses and
gains due to exchange rate fluctuations in the operating appropriations of the DoD. To prevent the foreign currency losses from adversely affecting mission readiness
and effectiveness, this account — Foreign Currency Fluctuations, Defense — funded the differences between obligations recorded at the budget rate of exchange and the
actual liquidated rate
4
. As outlined in DoD 1987, the Comptroller transfers amounts from the Foreign
Currency Fluctuations, Defense Appropriation to the centrally managed allotments CMA for each service. These funds are then available to cover currency losses in
any of 16 currencies subject to need and budgetary constraints
5
. Overseas activities convert their projected unliquidated foreign currency obligations for the budget
year to US dollars using the designated annual budget rate. At the time of liquidation, differences between the dollar equivalent of the foreign obligation
recorded at the budget rate and dollar outlay at the then-current rate are charged or credited to the CMA of the relevant component
6
. The current procedures may be less than optimal for three reasons. First,
resource constraints limit the DoD’s continued ability to pass the costs of currency fluctuation along to the taxpayer. Second, the desire to lower operations expenses
in favor of increased procurement prompts a reevaluation of the DoD’s current naı¨ve approach
7
. A systematic exploration of alternatives might reveal opportuni-
3
This usually occurs in late November or early December of the previous fiscal year, although rates can be changed at any point throughout the budget cycle to reflect significant changes in foreign
currency markets.
4
In FY1987, a separate account was initiated to isolate the longer-term military construction appropriation. This includes not only expenses for Military Construction, but also Family Housing
Construction, Family Housing OM, and NATO infrastructure. In FY1994, a separate accounting was undertaken within the FCFD account to track differences relative to overseas health care expenses. See
DoD Financial Management Regulation — Foreign Currency Reports, Vol. 6, Ch. 7 for specific reporting requirements.
5
Currencies include Belgian franc, British pound, Canadian dollar, Danish krone, Dutch guilder, French franc, German mark, Greek drachma, Italian lira, Japanese yen, Norwegian krone, Portuguese
escudo, Singapore dollar, South Korean won, Spanish peseta, and Turkish lira.
6
Only amounts resulting from actual currency fluctuation can be charged to the CMA. Differences due to changes in the cost, magnitude, or scope of requirements must be charged to the operating
appropriation.
7
Defense funding has declined 23 in real terms constant fiscal year 1998 dollars since 1991 with a 31.5 real decline in the Operations and Maintenance appropriation versus a 49 decline in the
Procurement appropriation Cohen, 1997.
ties for cost reduction. Last, the DoD’s prevailing bias against foreign currency hedging maintains a high degree of uncertainty in the formulation and execution of
overseas commitments. Current practice does not eliminate risk from foreign currency fluctuation, it merely defers its realization beyond the budgeting phase. In
the next section, we develop a generic decision model to examine alternative methods of dealing with the DoD’s foreign currency exposure in light of these
motivating factors.
3. Method
